Econ214 macroeconomics Chapter 3
- 2. 3-2 Learning Objectives 1.Use opportunity cost to explain the rationale for specialization and trade 2.Explain how markets allow specialization and trade 3.List the roles of government in a market economy
- 3. 3-3 P R I N C I P L E O F V O L U N T A R Y E X C H A N G E A voluntary exchange between two people makes both people better off. Comparative Advantage versus Absolute Advantage ● absolute advantage The ability of one person or nation to produce a product at a lower resource cost than another person or nation. ● comparative advantage The ability of one person or nation to produce a good at a lower opportunity cost than another person or nation. 3.1 COMPARATIVE ADVANTAGE AND EXCHANGE (cont.)
- 4. 3-4 The Division of Labor and Exchange In his 1776 book, An Inquiry into the Nature and Causes of the Wealth of Nations, Adam Smith noted that specialization actually increased productivity through the division of labor. Smith listed three reasons for productivity to increase with specialization, with each worker performing a single production task: 1 Repetition. The more times a worker performs a particular task, the more proficient the worker becomes at that task. 2 Continuity. A specialized worker doesn’t spend time switching from one task to another. This is especially important if switching tasks requires a change in tools or location. 3 Innovation. A specialized worker gains insights into a particular task that lead to better production methods. 3.1 COMPARATIVE ADVANTAGE AND EXCHANGE (cont.)
- 5. 3-5 Comparative Advantage and International Trade ● import A product produced in a foreign country and purchased by residents of the home country. ● export A product produced in the home country and sold in another country.
- 6. 3-6 Outsourcing When a domestic firm shifts part of its production to a different country, we say the firm is outsourcing or offshoring. 1 The loss of domestic jobs resulting from outsourcing is a normal part of a healthy economy, because technology and consumer preferences change over time. 2 The jobs lost to outsourcing are at least partly offset by jobs gained through insourcing, jobs that are shifted from overseas to the United States. 3 The cost savings from outsourcing are substantial, leading to lower prices for consumers and more output for firms. The jobs gained from increased output at least partly offset the jobs lost to outsourcing. Some recent studies of outsourcing have reached a number of conclusions:
- 7. 3-7 ● market economy An economy in which people specialize and exchange goods and services in markets. Although it appears that markets arose naturally, a number of social and government inventions have made them work better: • Contracts specify the terms of exchange, facilitating exchange between strangers. • Insurance reduces the risk entrepreneurs face. • Patents increase the profitability of inventions, encouraging firms to develop new products and production processes. • Accounting rules provide potential investors with reliable information about the financial performance of a firm. 3.2 MARKETS
- 8. 3-8 ● centrally planned economy An economy in which a government bureaucracy decides how much of each good to produce, how to produce the good, and who gets the good. Virtues of Markets Under a market system, decisions are made by the millions of people who already have information about consumers’ desires, production technology, and resources. These decisions are guided by prices of inputs and outputs. Prices provide signals about the relative scarcity of a product and help an economy respond to scarcity. The market system works by getting each person, motivated by self- interest, to produce products for other people. 3.2 MARKETS (cont.)
- 9. 3-9 The Role of Entrepreneurs Entrepreneurs play a key role in a market economy. ▪ Prices and profits provide signals to entrepreneurs about what to produce. ▪ If a product becomes popular, competition among consumers to obtain it will increase its price and increase the profits earned by firms producing it. ▪ Entrepreneurs will enter the market and increase production to meet the higher demand, switching resources from the production of other products. ▪ As entrepreneurs enter the market, they compete for customers, driving the price back down to the level that generates just enough profit for them to remain in business. 3.2 MARKETS (cont.)
- 10. 3-10 Although markets often operate efficiently on their own, sometimes they do not. Market failure happens when a market doesn’t generate the most efficient outcome. There are several sources of market failure and possible responses by government. Here is a preview of the topics: • Pollution. • Public goods. • Imperfect information. • Imperfect competition. 3.3 MARKET FAILURE AND THE ROLE OF GOVERNMENT
- 11. 3-11 Government Enforces the Rules of Exchange • To facilitate exchange, the government helps to enforce contracts by maintaining a legal system that punishes people who violate them. This system allows people to trade with the confidence that the terms of the contracts they enter will be met. • In the case of consumer goods, the implicit contract is that the product is safe to use. The government enforces this implicit contract through product liability or tort law. • The government disseminates information about consumer products. • The government uses antitrust policy to foster competition. 3.3 MARKET FAILURE AND THE ROLE OF GOVERNMENT (cont.)
- 12. 3-12 Government Can Reduce Economic Uncertainty • Given the uncertainty of market economies, most governments fund a “social safety net” that provides for citizens who fare poorly in markets. • Of course, there are private responses to economic uncertainty. For example, we can buy our own insurance to cover losses. • Some types of insurance, however, are unavailable in the private insurance market. As a result, the government steps in to fill the void. 3.3 MARKET FAILURE AND THE ROLE OF GOVERNMENT (cont.)
- 13. 3-13 K E Y T E R M S absolute advantage centrally planned economy comparative advantage export import market economy
- 14. Chapter 4 Demand, Supply, and Market Equilibrium
- 15. 3-15 Learning Objectives 1. Describe and explain the law of demand 2. Describe and explain the law of supply 3. Explain the role of price in reaching a market equilibrium 4. Describe the effect of a change in demand on the equilibrium price 5. Describe the effect of a change in supply on the equilibrium price 6. Use information on price and quantity to determine what caused a change in price
- 16. 3-16 DEMAND, SUPPLY, AND MARKET EQUILIBRIUM ● perfectly competitive market A market with many buyers and sellers of a homogeneous product and no barriers to entry.
- 17. 3-17 ● quantity demanded The amount of a product that consumers are willing and able to buy. ● demand schedule A table that shows the relationship between the price of a product and the quantity demanded, ceteris paribus. 4.1 THE DEMAND CURVE
- 18. 3-18 Here is a list of the variables that affect an individual consumer’s decision, using the pizza market as an example: • The price of the product (for example, the price of a pizza) • The consumer’s income • The price of substitute goods (for example, the prices of tacos or sandwiches or other goods that can be consumed instead of pizza) • The price of complementary goods (for example, the price of lemonade or other goods consumed with pizza) • The consumer’s preferences or tastes and advertising that may influence preferences • The consumer’s expectations about future prices 4.1 THE DEMAND CURVE (cont.)
- 19. 3-19 The Individual Demand Curve and the Law of Demand ● law of demand There is a negative relationship between price and quantity demanded, ceteris paribus. ● change in quantity demanded A change in the quantity consumers are willing and able to buy when the price changes; represented graphically by movement along the demand curve. ● individual demand curve A curve that shows the relationship between the price of a good and quantity demanded by an individual consumer, ceteris paribus. 4.1 THE DEMAND CURVE (cont.)
- 20. 3-20 The Individual Demand Curve and the Law of Demand FIGURE 4.1 The Individual Demand Curve According to the law of demand, the higher the price, the smaller the quantity demanded, everything else being equal. Therefore, the demand curve is negatively sloped: When the price increases from $6 to $8, the quantity demanded decreases from seven pizzas per month (point c) to four pizzas per month (point b). 4.1 THE DEMAND CURVE (cont.)
- 21. 3-21 From Individual Demand to Market Demand ● market demand curve A curve showing the relationship between price and quantity demanded by all consumers, ceteris paribus. FIGURE 4.2 From Individual to Market Demand The market demand equals the sum of the demands of all consumers. In this case, there are only two, so at each price the market quantity demanded equals the quantity demanded by Al plus the quantity demanded by Bea. At a price of $8, Al’s quantity is four pizzas (point a) and Bea’s quantity is two pizzas (point b), so the market quantity demanded is six pizzas (point c). Each consumer obeys the law of demand, so the market demand curve is negatively sloped. 4.1 THE DEMAND CURVE (cont.)
- 22. 3-22 LAW OF DEMAND AND CIGARETTES APPLYING THE CONCEPTS #1: What is the Law of Demand? A P P L I C A T I O N 1 • As price decreases and we move downward along the market demand for cigarettes, the quantity of cigarettes demanded increases for two reasons. First, people who smoked cigarettes at the original price respond to the lower price by smoking more. Second, some people start smoking. • A change in cigarette taxes in Canada illustrates the second effect, the new-smoker effect. In 1994, several provinces in eastern Canada cut their cigarette taxes and the price of cigarettes in the provinces decreased by roughly 50 percent. Researchers tracked the choices of 591 youths from the Waterloo Smoking Prevention Program, and concluded that the lower price increased the smoking rate by roughly 17 percent.
- 23. 3-23 Suppose you ask the manager of a firm, “How much of your product are you willing to produce and sell?” The manager’s decision about how much to produce depends on many variables, including the following, using pizza as an example: • The price of the product (for example, the price per pizza) • The wage paid to workers • The price of materials (for example, the price of dough and cheese) • The cost of capital (for example, the cost of a pizza oven) • The state of production technology (for example, the knowledge used in making pizza) • Producers’ expectations about future prices • Taxes paid to the government or subsidies (payments from the government to firms to produce a product) 4.2 THE SUPPLY CURVE
- 24. 3-24 The Individual Supply Curve and the Law of Supply ● supply schedule A table that shows the relationship between the price of a product and quantity supplied, ceteris paribus. ● individual supply curve A curve showing the relationship between price and quantity supplied by a single firm, ceteris paribus. ● quantity supplied The amount of a product that firms are willing and able to sell. 4.2 THE SUPPLY CURVE (cont.)
- 25. 3-25 The Individual Supply Curve and the Law of Supply FIGURE 4.3 The Individual Supply Curve The supply curve of an individual supplier is positively sloped, reflecting the law of supply. As shown by point a, the quantity supplied is zero at a price of $2, indicating that the minimum supply price is just above $2. An increase in price increases the quantity supplied to 100 pizzas at a price of $4, to 200 pizzas at a price of $6, and so on. 4.2 THE SUPPLY CURVE (cont.)
- 26. 3-26 The Individual Supply Curve and the Law of Supply ● law of supply There is a positive relationship between price and quantity supplied, ceteris paribus. ● change in quantity supplied A change in the quantity firms are willing and able to sell when the price changes; represented graphically by movement along the supply curve. ● minimum supply price The lowest price at which a product will be supplied. 4.2 THE SUPPLY CURVE (cont.)
- 27. 3-27 Why Is the Individual Supply Curve Positively Sloped? From Individual Supply to Market Supply ● market supply curve A curve showing the relationship between the market price and quantity supplied by all firms, ceteris paribus. M A R G I N A L P R I N C I P L E Consistent with the Law of Supply, increase the level of an activity as long as its marginal benefit exceeds its marginal cost. Choose the level at which the marginal benefit equals the marginal cost. 4.2 THE SUPPLY CURVE (cont.)
- 28. 3-28 From Individual Supply to Market Supply FIGURE 4.4 From Individual to Market Supply The market supply is the sum of the supplies of all firms. In Panel A, Lola is a low-cost producer who produces the first pizza once the price rises above $2 (shown by point a). Panel B, Hiram is a high-cost producer who doesn’t produce pizza until the price rises above $6 (shown by point f ). To draw the market supply curve, we sum the individual supply curves horizontally. At a price of $8, market supply is 400 pizzas (point m), equal to 300 from Lola (point d) plus 100 from Hiram (point g). 4.2 THE SUPPLY CURVE (cont.)
- 29. 3-29 From Individual Supply to Market Supply FIGURE 4.5 The Market Supply Curve with Many Firms The market supply is the sum of the supplies of all firms. The minimum supply price is $2 (point a), and the quantity supplied increases by 10,000 for each $2 increase in price to 10,000 at a price of $4 (point b), to 20,000 at a price of $6 (point c), and so on. 4.2 THE SUPPLY CURVE (cont.)
- 30. 3-30 Why Is the Market Supply Curve Positively Sloped? To explain the positive slope, consider the two responses by firms to an increase in price: • Individual firm. As we saw earlier, a higher price encourages a firm to increase its output by purchasing more materials and hiring more workers. • New firms. In the long run, new firms can enter the market and existing firms can expand their production facilities to produce more output. 4.2 THE SUPPLY CURVE (cont.)
- 31. 3-31 LAW OF SUPPLY AND WOOLYMPICS APPLYING THE CONCEPTS #2: What is the Law of Supply? A P P L I C A T I O N 2 • In the 1990s, the world price of wool decreased by about 30 percent, and prices have remained relatively low since then. Based on the law of supply, we would expect the quantity of wool supplied in New Zealand and other exporters to decrease, and that’s what happened. Land that formerly grew grass for wool- producing sheep has been converted into other uses, including dairy products, forestry, and the domestication of deer. • There have been several attempts to revive the wool industry by boosting the demand for wool and thus increase its price. The United Nations General Assembly declared 2009 as the International Year of Natural Fibers, with the objective “to raise awareness and stimulate demand for natural fibers.” In 2012, the Federated Farmers of New Zealand proposed that sheep shearing be added to the Commonwealth Games and Olympics as a demonstration sport. Of course, it’s not obvious that Olympic shearing would increase the demand for wool, and then there is the problem of what to do with all the sheared wool. Extreme knitting?
- 32. 3-32 Excess Demand Causes the Price to Rise ● excess demand (shortage) A situation in which, at the prevailing price, the quantity demanded exceeds the quantity supplied. Excess Supply Causes the Price to Drop ● excess supply (surplus) A situation in which the quantity supplied exceeds the quantity demanded at the prevailing price. ● market equilibrium A situation in which the quantity demanded equals the quantity supplied at the prevailing market price. 4.3 MARKET EQUILIBRIUM: BRINGING DEMAND AND SUPPLY TOGETHER
- 33. 3-33 FIGURE 4.6 Market Equilibrium At the market equilibrium (point a, with price = $8 and quantity = 30,000), the quantity supplied equals the quantity demanded. At a price below the equilibrium price ($6), there is excess demand—the quantity demanded at point c exceeds the quantity supplied at point b. At a price above the equilibrium price ($12), there is excess supply—the quantity supplied at point e exceeds the quantity demanded at point d. 4.3 MARKET EQUILIBRIUM: BRINGING DEMAND AND SUPPLY TOGETHER (cont.)
- 34. 3-34 Change in Quantity Demanded versus Change in Demand ▼ FIGURE 4.7 Change in Quantity Demanded versus Change in Demand ● change in demand A shift of the demand curve caused by a change in a variable other than the price of the product. (A) A change in price causes a change in quantity demanded, a movement along a single demand curve. For example, a decrease in price causes a move from point a to point b, increasing the quantity demanded. (B) A change in demand caused by changes in a variable other than the price of the good shifts the entire demand curve. For example, an increase in demand shifts the demand curve from D1 to D2. 4.4 MARKET EFFECTS OF CHANGES IN DEMAND
- 35. 3-35 Increases in Demand Shift the Demand Curve ● normal good A good for which an increase in income increases demand. ● inferior good A good for which an increase in income decreases demand. ● substitutes Two goods for which an increase in the price of one good increases the demand for the other good. ● complements Two goods for which a decrease in the price of one good increases the demand for the other good. 4.4 MARKET EFFECTS OF CHANGES IN DEMAND (cont.)
- 36. 3-36 change in demand change in quantity demanded change in quantity supplied change in supply complements demand schedule excess demand (shortage) excess supply (surplus) individual demand curve individual supply curve inferior good K E Y T E R M S law of demand law of supply market demand curve market equilibrium market supply curve minimum supply price normal good perfectly competitive market quantity demanded quantity supplied substitutes supply schedule